Investopedia's Guide To Etf Investing: Getting Started

Exchange-traded funds (ETFs) are a type of investment fund that combines the benefits of stocks and mutual funds. They are a basket of investments like stocks or bonds that can be traded on exchanges, just like stocks. ETFs are usually passively managed and aim to match the performance of an underlying benchmark index. They provide instant diversification, lower fees, and are easily traded, making them an attractive option for investors.

ETFs were first introduced in 1993, and as of November 2023, over 3,000 ETFs were listed on U.S. exchanges, with combined assets exceeding $7.6 trillion. The popularity of ETFs has continued to grow due to their accessibility, low costs, and ability to provide exposure to a wide range of asset classes, industry sectors, and international markets.

However, it is important to note that ETFs carry unique risks, such as commissions and expenses, underlying fluctuations, and reduced taxable income flexibility. Investors should carefully consider these factors and conduct thorough research before investing in ETFs.

Passive vs. active ETFs

There are two basic types of ETFs: passive and active. Passive ETFs, also known as index funds, track a stock index such as the S&P 500. Active ETFs, on the other hand, hire portfolio managers to actively manage and trade securities within the ETF with the goal of outperforming an index.

Passive ETFs are a popular strategy for investors who prefer a long-term, buy-and-hold approach, whereas active ETFs are an alternative for those seeking to outperform the market. Passive ETFs tend to be lower-cost and more transparent, but they do not provide any potential for outperformance (alpha). Active ETFs, meanwhile, aim to deliver above-average returns but tend to have higher management expenses.

Passive ETFs

Passive investing focuses on tracking and achieving the return of a specific index, and it involves limited transactions. Passive ETFs aim to replicate the performance of a broader index, such as the S&P 500, or a more targeted sector or trend. They tend to follow buy-and-hold strategies and are known for their cost-efficiency, generally having lower management fees. The fund manager of a passive ETF does not make allocation decisions but simply tracks the chosen index.

Active ETFs

Active ETFs, in contrast, utilise a portfolio manager's investment strategy in an attempt to outperform a benchmark. Actively managed ETFs involve a fund manager or team that researches investment opportunities and actively selects the ETF's portfolio securities and allocation according to their investment goals. These ETFs provide the potential for above-average returns but come with higher fees.

The fundamental premise of active management is to generate alpha, or returns above and beyond the benchmark index. Active ETFs create greater opportunities to deviate from standard market returns, and investors in active ETFs have performance expectations tied to the skills and expertise of the portfolio managers.

If you prefer a long-term, buy-and-hold approach to investing, passive ETFs may be more suitable. On the other hand, if you seek the potential for returns that outpace the broad market and other indexes, you may wish to consider including active ETFs in your portfolio.

Expense ratios

ETF expense ratios are typically low, with some of the lowest being 0.03% and 0.05%. The average expense ratio for Vanguard's ETFs is currently 0.05%, compared to the industry average of 0.22%.

Mutual funds generally have higher expense ratios than ETFs. While ETF expense ratios average about 0.22%, mutual fund costs can be significantly higher. For example, the largest ETF, the SPDR S&P 500 ETF (SPY), has a relatively high expense ratio of 0.0945% for an ETF.

Actively managed funds tend to have higher expense ratios than passively managed funds, which simply track an index. The average expense ratio for active funds was 0.59% in 2022, while for passive funds, it was about 0.12%.

When choosing an investment, it is important to consider the expense ratio as it will impact your overall returns. Even a small difference in expense ratios can cost you a lot of money in the long run.

There are several ways to determine the expense ratio of a fund, including fund prospectuses, financial news websites, fund screeners, and news journals.

Dividends and DRIPs

Most ETFs pay dividends. Dividends are a portion of earnings allocated or paid by companies to investors for holding their stock. You can choose to have your ETF dividends paid to you as cash, or you can choose to have them automatically reinvested through a dividend reinvestment plan, or DRIP.

DRIPs are dividend reinvestment plans that allow investors to reinvest their cash dividends into additional shares or fractional shares of the underlying stock on the dividend payment date. DRIPs are widely available and easy to set up. They are a smart idea because there is often a longer settlement time required by ETFs. Their market-based trading can make manual dividend reinvestment inefficient.

DRIPs are usually offered by the fund or brokerage firm, but if your brokerage firm doesn't provide a DRIP option, or if the ETFs in which you are invested don't allow for automatic reinvestment, you can still reinvest dividends manually. This means taking the cash earned from a dividend payment and executing an additional trade to buy more shares of the ETF. You may incur a commission charge for these trades, depending on where you hold your investment account.

DRIPs offer greater convenience and a handy way to grow your investments effortlessly. They also eliminate problems with timing the reinvestment of ETF dividends. However, a disadvantage of automatic dividend reinvestments is that investors lose the ability to time the market.

Note that dividends paid into DRIPs are taxed even though they are used to purchase shares. The only way to avoid paying taxes on reinvested dividends in the year they're earned is by holding those stocks in a tax-advantaged plan, such as a 401(k).

Understanding ETF taxes

The tax efficiency of ETFs is a significant part of their appeal to investors. Here's what you need to know about ETF taxes:

ETF Taxes vs Mutual Funds Taxes:

ETFs are often considered more tax-efficient than mutual funds due to their structure. ETFs create and redeem shares using in-kind transactions, which aren't considered sales and therefore don't trigger taxable events. Mutual funds, on the other hand, typically incur more capital gains over time as they buy and sell securities within the fund, passing these capital gains on to investors as distributions.

Tax Rules for ETFs:

The tax rules for ETFs depend on the type of assets they hold. Profits from selling ETFs held for under a year are taxed as short-term capital gains, while those held for longer are taxed as long-term capital gains at a lower rate. If you sell an ETF and buy the same one within 30 days, you may be subject to the wash sale rule, which means you can't offset other capital gains. High earners may also be subject to the net investment income tax on ETF sales.

Dividends and Interest Payments:

Dividends and interest payments from ETFs are taxed like income from the underlying stocks or bonds they hold. Dividends can be ordinary (taxable) or qualified (taxed at lower capital gains rates). Interest payments from bond ETFs are considered ordinary dividends.

Exceptions:

There are special tax rules for certain types of ETFs. Currency ETFs, for example, are typically taxed as ordinary income, even if held for several years. ETFs that invest in futures are treated with the 60/40 rule, where 60% of gains or losses are treated as long-term and 40% as short-term, regardless of the holding period. Crypto ETFs, depending on their structure, may follow similar rules to futures-based ETFs or be taxed as ordinary income.

Tax Strategies:

ETFs offer opportunities for tax planning. One strategy is to sell ETFs with losses before their one-year anniversary to take advantage of short-term capital loss treatment. Another strategy is to sell an ETF in a declining sector and buy a similar but different ETF to maintain exposure while realising a loss for tax purposes.

How to start investing in ETFs

Step 1: Understand the basics of ETFs

Before investing in Exchange-Traded Funds (ETFs), it is important to understand what they are and how they work. ETFs are baskets of stocks, bonds, or other assets that trade on stock exchanges like regular stocks. They are usually passively managed, aiming to match the performance of an underlying benchmark index. ETFs offer instant diversification, low fees, and easy trading compared to other investment options.

Step 2: Open a brokerage account

To start investing in ETFs, you will need to open a brokerage account. Most online brokers offer commission-free ETF trades, so you can compare their features and platforms to choose the one that best suits your needs. If you are new to investing, consider choosing a broker with extensive educational resources and tools.

Step 3: Choose your first ETFs

When selecting your first ETFs, it is generally recommended to start with passive index funds, which are cheaper and often outperform actively managed funds. Consider factors such as the underlying index or asset class, diversification, tracking error, and the ETF's market position. Additionally, evaluate the ETF's expense ratio, which represents the annual fees associated with managing the fund.

Step 4: Make your purchases

After selecting your desired ETFs, you can use your brokerage account to buy shares in the same way you would purchase stocks. You can buy and sell ETFs throughout the trading day, taking advantage of intraday price fluctuations.

Step 5: Monitor and adjust your portfolio

Once you have purchased your ETFs, it is important to periodically review and adjust your portfolio as needed. While ETFs are generally designed to be maintenance-free investments, staying informed about market trends and the performance of your investments is crucial. Remember that investing carries inherent risks, and the value of your investments can fluctuate over time.

Frequently asked questions